Economic Logic, Too

About Me

I discuss recent research in Economics and various events from an economic perspective, as the name of the blog indicates. I plan on adding posts approximately every workday, with some exceptions, for example when I travel.

Friday, October 24, 2008

We have all heard about the controversy whether minimum wages increase or decrease low-wage employment. But what is its effect on wages? Presumably, the idea of the minimum wage is to raise the lowest wages to a level that makes them living wages. What about the other wages?

Natalya Shelkova suggests that the workers with productivities not much higher that the minimum wages get their wage depressed to the minimum wage. The reason is that the minimum wage acts like a coordination device for employers who thus implicitly collude to offer lower wages. Empirically, she shows that this happens more in states that follow the federal minimum wage, as well as at times where the minimum wages has not been changed for a long time. This implies that introducing a minimum wage reduces wages, at least for those who had wages reasonably close to this new minimum. However, increasing an existing minimum wage raises wages.

The reasoning is similar to that of Christopher Knittel and Victor Stango for credit card interest rates. Once maximum rates were defined by state laws, financial institutions quickly converged to those rates which then not only were maximum rates, but also median rates. It shows that sometimes good intentions can backfire.

NB: I will traveling next week, so I may not be able to post every day, if any.

Thursday, October 23, 2008

At least since the work of Kjetil Storesletten, we know that it is possible to find an immigration policy that can make social security sustainable. But is such a policy politically feasible, taking xenophobia aside?

Edith Sand and Assaf Razin address this question with a very simple overlapping-generations model. Obviously, old people prefer having lots of (young) immigrants as well as high tax rates that will both sustain their pensions (we are talking about a pay-as-you-go plan). Young people clearly prefer low tax rates on their income, but it is unclear what they prefer in terms of immigration policy. They like high immigration quotas because it implies that there will be more when they are old, as immigrants have higher fertility rates. But they also like lower rates for the following reason: immigrants once old have the right to vote, as their descendants. Due to their fertility, this may shift the median voter from the old to the young and thus reduce future pensions. To top all this, immigrants depress wages (what the young do like) but increase the return of capital (what the old like).

All this implies that there can be immigration policy cycles. If the country is primarily populated by old people, it will let in a lot of immigrants. But once the young are in majority, borders are closed, until the old get sufficiently numerous. Guess where we are headed.

Wednesday, October 22, 2008

Marriage is an implicit contract that is very difficult (and costly) to renege on. But it is an institution that has been around for a very long time, so it must be satisfying some need from both parties. There must be some Economics involved, right?

Gilles Saint-Paul offers an explanation: it is all about the children. Just from biology, women know which children are theirs. But to convince men they are the legitimate fathers, women need to offer a marriage contract and thereby forgo potentially better opportunities for other men. Men are fine with this contract, despite the fact that they could have mated with other women, because they are assured of the legitimacy of their children, and that it is worthwhile investing in them. For this contract to be credible, women must be able to commit to the marriage and thus accept penalties in case of adultery. Men do not need to, though, because it works against their interest to recognize their children.

What does this entail for investment in human capital? Assume human capital is at least partly inherited. Clearly, men will provide more effort if they can recognize their children. But it matters also what kind of marriage matches happen. By committing to a man, a woman passes on future better opportunities. But, unlike some other contracts, she is unable to transfer utility if she marries a male of lesser quality. This means that the marginal utility of consumption is lower for a women of higher human capital and she will require a much larger transfer from the male for forgoing future opportunities. For men, the more human capital they have, the lower the marginal utility and the more they are willing to invest in their kids.

It turns there are two possible equilibria here: A so-called Victorian one, where there is positive assortative matching with women marrying men with the same human capital. But there can also be a so-called Sex and the City one, where men marry women with lower human capital, and there are high human capital ones that are not satisfied with the remaining low human capital men. The latter is more likely if the distribution of human capital becomes more unequal, as some women (dumb blondes?) can underbid more intelligent ones. In aggregate terms, this means also that there is less talent in the next generation.

Tuesday, October 21, 2008

I finally came around to read Olivier Blanchard's State of Macro paper that was discussed in other blogs when it came out. I am not sure I have the same reading about the state of macro that he has.

While I agree there has been convergence, the real convergence, and it is phenomenal, is between microeconomics and macroeconomics. I consider macro now to be a subfield of micro, so much is the use of microfoundations pervasive. Nowadays, macroeconomists can actually be understood by people outside their field, and vice-versa. The only difference is in the kind of questions they ask.

I do not understand his aversion to reverse-engineering a model. When you observe the data, you try to find a model that fits the data. You may take a general class of models and then narrow it down to the one(s) that correspond best to the data. Heck, isn't exactly what structural estimation is doing, reverse-engineering a model?

Olivier Blanchard is an unabated neo-keynesian. He is still trying to find some way in micro-foundations to justify the Phillips curve, or even IS-LM. He uses Calvo pricing and pretends this is general equilibrium. With Calvo pricing, he also assumes from the start that rigidities matter, while empirical evidence about this is mixed. He insists on analytical solutions so that a model can be reduced to a few equations. As far as I understand it, macro has evolved since those days where you were limited by tractability. With computers, you can solve more realistic models that may actually highlight complex relationships. You can find numerical answers to questions that remain ambiguous in an analytical setting. But this is now old neo-keynesianism.

In fact, V. V. Chari, Patrick Kehoe and Ellen McGrattan seem to have written a response to the Blanchard piece, essentially claiming that the shortcuts that neo-keynesians take do not render their models useful for policy. This trio of authors has written a series of controversial papers, but the current one is one I can agree with the most readily. The new generation of neo-keynesian models are bloated, tend to deviate from microeconomic principles and add lots of free parameters in order to fit the data better. In that vein, one can do better with neural networks where basically anything goes as long as it fits. But you gain no understanding of the economy.

The greatest advance in macroeconomics since Lucas, Sargent and Prescott has been the use of solidly founded theory. Neo-keynesians have consistently fought against this once they realized their favorite equations could not be justified. Blanchard is still fighting this battle, and although he made concessions, he lost that war. The new battleground is on getting these models usable for policy. Neo-keynesians are ahead in policy circles, but only because they have again renounced on the very principle of modern macro, the consistent use of theory and microfoundations.

Monday, October 20, 2008

If you still think that people are honest on Wall Street, you need to read the article on forensic finance in the latest issue of the Journal of Economic Perspectives. Jay Ritter documents several frauds that were so widespread that they were discovered by looking at aggregate data, thus instigating investigations.

Ritter documents four examples. The first the so-called late trading of mutual funds. Their price is set at the end of the trading day, but predictable market movements, say due to major announcements made while the market is closed, implies that their value continues changing. Yet some sold shares at old prices, because either they were in exchange allowed to invest in vehicles that were generating high fees, or employees where plainly enriching themselves.

The second example pertains to employee stock options backdating, whereby options where given with an exercise price set at the market price of the share, as required by law, but at the lowest price in recent trading. In other words, firms where pretending their filing was late, while it was really on time with an old price. Just from looking at abnormal stock returns around stock option grants, it became obvious that those returns where more than 3% lower on aggregate for firms that do not have a fixed stock option granting calendar. A major scandal ensued, and it uncovered that firms that were backdating lost 7% on the stock market. All this for allowing executives to gain on average half a million dollars annually per firm.

The third example is the so-called spinning of IPOs, that is, offering underpriced new shares to privileged people. As IPOs were generally oversubscribed (and could thus have been priced higher), bookrunners could choose whom to sell them. Of course, they chose those who could provide them with other favors, either separate deals or in the case of executives, loyalty. And said executives were fine with the underpricing that cost their firms.

The final example pertains to something that looked like fraud, but ended up being "just" incompetence. The Thomson Financial I/B/E/S database of analyst recommendations had at some times about 30% of the recommendations altered after the fact, putting them more in line with actual outcomes. While this looked like rewriting history to highlight the competence of these analysts, it turns out the coding and data entry policies were horrendous. Yet plenty of investors relied on this data. Such incompetence seem also present in rating agencies and elsewhere.

Some have called the increased government involvement in financial markets a step back. But looking as these generalized frauds or examples of incompetence, it seems regulation and consistent disclosure requirements that are also verified are necessary.

Friday, October 17, 2008

Now that the presidential campaign in the United States is finally entering its last stretch, let me expose my thinking about what I look for in a president, whether it is this year or other years.

The president should be an exceptional person. It is an exceptional job and it requires exceptional abilities. The interact with world leaders that are also exceptional people.

The president should be surrounded by competent people. Competent, but not with vested interests. For example, the Secretary for Agricultural should not be a farmer, but should still be competent, and himself be surrounded by competent people.

The president should listen. He cannot know everything, and gut feelings are sometimes wrong. Also, environments change and decisions need to be revised.

The president should understand that there is something between white and black. Learn about the pros and the cons, and take both into account. Incorporate side effects into decisions. Listen to minorities.

The president should be a leader. Once decisions are reached, he should be able to rally the administration and especially federal staff towards implementing them.

The president should be an explainer. Sometimes, unpopular decisions need to be taken. The president should be able to convince people that this is the right choice.

The president should be open to challenge. He should welcome challenging questions from the press. He should answer question in Congress.

Note that I did not mention any opinion on policy. The two candidates are very close in this regard, and at this point policies are secondary to my points above. And besides, there is always a gap between election promises and actual outcomes once reality sets in.

Thursday, October 16, 2008

It is becoming increasingly popular to delay the entrance of children into first grade, or red-shirting them to use a term for university sports. The idea of parents is to give their offspring a competitive edge throughout their academic career as they would be more mature. While this should clearly work in the early grades, does this work for educational outcomes?

David Deming and Susan Dynarski claim it does not work, in fact there is even evidence that it is counterproductive. They show that red-shirted children make a slower progression through grades, going even as far as demonstrating that most of the slowdown in grade attainment over the past 30 years is due to the delay in school entrance. There is also a significant effect for the attainment of an undergraduate degree. Finally, delayed school entry also entails a shorter time spent thereafter in the labor force.

Why would parents still want to red-shirt their kids? They would clearly have advantages in non-academic areas: less subject to bullying, better at sports. In fact, I have heard the latter argument from other parents. While there is clearly an overemphasis on competitive sports in America schools (witness parents calling for less homeworks so the kids can train more), some argue that sports scholarships are the only way to finance a college education. School officials are also tempted by this practice, because it allows to have better students in a particular grade, and the school looks better in assessments.

While red-shirting does not seem to carry advantages for the children, it is a clear disadvantage for kids who enter school on time. They are typically of lower socio-economic status and face an even higher gap in the classroom. In this respect, this may also lead parents to red-shirt their children in order to avoid these disadvantages. This lead to competitive delays and a clearly negative outcome for society.

Wednesday, October 15, 2008

Soon after yesterday's post about the surprising increase in US adult literacy between ages 16-17 and 26-30, I stumble in the latest NEP dispatch on a working paper that seems relevant. Diego Restuccia and Guillaume Vandenbroucke point out that educational attainment as increased constantly from 1940 to 2000 and try to find a reason for it. They conclude that the skill premium in wages is the main motivator for people to get more educated. So far so good.

But they also show that all this is driven by skill-biased technological change. This is where the results do not seem to square with the paper discussed yesterday. If US students catch up late on adult literacy, it is because they are getting general education in college. In Europe, however, college is specialized from the start. If this is an equilibrium outcome, I would have expected technological change to be skilled-biased in Europe and be more general in the US. This is confirmed by the low mobility of the European labor force (and the ensuing high unemployment rate) that has a hard time changing sectors or occupations if necessary, at least compared to the United States.

Tuesday, October 14, 2008

Browsing through the latest issue of the Journal of Economic Perspectives, I stumbled on puzzling numbers on education in the article by Elizabeth Cascio, Damon Clark and Nora Gordon: while the United States is severely lagging in literacy for 16-17 year olds among countries with similar income levels, it is in the middle of the pack for ages 26-30. This is based on the International Adult Literacy Survey, which tests how well respondents answer to questions after reading a text.

That the performance of school students in the US is poor should surprise no one. What I find surprising is how well they catch up on the other countries later on. It is true that university graduation rates used to be higher than anywhere else, but this has changed now. Also, I am not convinced that a diploma in the US is worth the same as in other countries. However, the first two years in US colleges are typically spent furthering general education which has already been acquired in high school elsewhere. Can this explain the catching up? At least part of it. But I cannot believe that US college students learn that much to pass the Italian, Swiss or Danish ones.

Monday, October 13, 2008

He uses his model to figure out out where presidential candidates should spend most of their time. Again, Florida comes on top, followed by Ohio, Pennsylvania, Michigan, Virginia and Colorado, which are the so-called battleground states. I am somewhat puzzled that California is next on the list: while loaded with electoral votes, it is a near certain Obama state.

Do candidates actually optimize? Obama does very well, with a correlation on 0.9. This is rather surprising given earlier promises to campaign in all states. But it is not surprising that McCain does not optimize well, with a correlation of 0.8. In particular, he spends a lot of time in New York, which he has a 0.3% chance of winning.

Friday, October 10, 2008

How is it possible that stocks could be dropping this fast all over the world while the current crisis is mostly limited to the US financial sector? Stock prices are supposed to represent the discounted present value of the expectations of future dividends, and possibly the liquidation value of the firms. What in that equation would lead to such price drops?

Lower expectations for dividends? Possibly, as people must by now realize that someone will have to pay for this horrible bailout package, and firms are likely to be the first ones on the hook in an election period. But that would not explain why stocks drop in the rest of the world, and it probably does not explain the amplitude of the drop in the US.

Changes in discounting? With the recent reduction in interest rates by the Federal Reserve Bank, we should in fact see increases in stock prices? So what is left? Irrational panic? While one cannot rule this out, there may be a perfectly rational explanation, and the lead article in the last American Economic Review gives one.

Ana Fostel and John Geanakoplos show how perfectly rational agents can generate something that looks like a panic. The premise is an economy populated with liquidity constrained individuals (no borrowing and short sales) who are heterogeneous in terms of optimism. They show that even a small group of agents heavily invested in a small sector of the economy can lead the economy into a so-called anxious state, where bad news is contagious for assets to which the news is orthogonal.

The crucial aspect is heterogeneity of agents combined with incomplete markets. The key is that some bad news increases volatility, because of the latter this does not necessarily increase the information. The result is more disparity in opinions. Some sell because of increased pessimism, others have to because of the liquidity constraint. It snowballs from there and looks like a panic, but everyone is acting in a rational manner.

Does this pertain to the current situation in the United States? The authors have emerging markets in mind, where indeed markets are much more incomplete than in the US. But the current US situation is one where it is very difficult to borrow and most agents never contemplate short sales, and some of those who do have just been forbidden to do so. And given that the model economy just needs few people in such a situation, I think the model applies.

Thursday, October 9, 2008

Now that the US has passed this unfortunate bailout package, other governments around the world are eager to pursue similar policies. This is quite silly, as we seem to create a gigantic moral hazard problem at great cost.

Iceland reached heights in silliness by taking over much of its banking sector. Icelandic banks had been very aggressive on European financial markets, in particular pursuing depositors with high interests rates. This means the banking sector is much larger than the country in that a majority of its customers are abroad. Why would the government then step in to save foreign customers? This is especially questionable as the Icelandic government is now itself in a situation of default as a consequence and is begging for money in Russia, of all places.

The only explanation I can think of for this decision is that Iceland just imitated US policy action without thinking too much. And other European governments are following suit as well, except for Switzerland. The latter is an interesting case, as UBS has been particularly bad hit by the subprime-mortgage situation. But knowing the government would not help, it recapitalized several months ago with funding from Asia, and it seems to be in relatively good shape now. The other big Swiss bank, Credit Suisse, is fundamentally healthy and has announced plans to hire 1000 investment bankers in anticipation of a rush of new customers. So much for preventing moral hazard problems: not intervening leads to a healthier financial sector.

Wednesday, October 8, 2008

A popular complaint by faculty is that they do not have enough time for research and spend too much time on teaching and administrativa. A common complaint of the general public is that faculty do not spend enough time teaching. While it is difficult to say what the optimal time allocations are, one can study what they currently are.

Albert Link, Christopher Swann and Barry Bozeman do this for science and engineering faculty using a survey a US research universities. The survey has a drawback that it uses recall, asking how much time the surveyed faculty member spent on various tasks over a typical week of the last term. There is plenty of evidence that such questions elicit inaccurate and, especially, biased responses, which is why I will not report on the number of hours.

Rather, I want to discuss on how the time allocation evolves over an academic career. First, the number of hours per week is remarkably stable over a career. The allocation varies significantly, though. Take teaching (including preparation time and student advising), which starts very high for the two first years. Given that new faculty typically have a lower teaching load, it is surprising to see how it still does not compensate for the additional prepping for new classes. Teaching time then steadily declines, presumably because prepping time decreases with experience, but then increases for associate professors who where not promoted to full professors. As they did not make it to higher level in terms of research, they are presumably asked to take more teaching responsibilities. Or they lie about the time spend on prepping. Or they are simply less efficient.

For time devoted to research, again there is a peak in the two first years, then an almost steady decline for those staying on as associate professors. Full professors, however, maintain research time steady from the point of promotion. Grant writing time, important in the sciences and engineering, does not fluctuate much over the career. However, time dedicated to "service" (committees, consulting) increases steadily, without much difference between titles. Other remarkable findings: non-tenured faculty works 2.5 more hours a week, women 1.2 more.

Would these results pertain to Economics faculty? I can only relate to my anecdotal evidence (and that of a few others I called about this). It seems that the research hours actually decline over their career. They get plenty of opportunities in consulting, especially for full professors, or they just stop doing research, especially long-term associate professors. For the latter, I have not noticed any additional time devoted to teaching, so I conclude their total hours must be declining. Readers may correct me if my observations are truly anecdotal.

Tuesday, October 7, 2008

The oldest trade usually pays well, even where it is legal. Why so? Prostitution is low-skilled, labor intensive and female, all attributes that are usually associated with low pay. Lena Edlund and Evelyn Korn have proposed that the high pay can be justified by that fact that prostitute give up their fertility. This is based on the taboos that prevent the marriage of prostitutes. But this is theory.

Raj Arunachalam and Manisha Shah provide an empirical test of this theory. They use sex worker data from Ecuador and Mexico. Prostitutes are indeed better paid, especially when young, when they are also more likely to be married. Even worse for the theory, the premium is higher for male sex workers.

The authors hypothesize that the true explanation for the higher pay is risk. Sex workers face much higher risks of catching sexually transmitted diseases. Some proof of this is that sex workers earn less when using a condom, as shown by Paul Gertler, Manisha Shah and Stefano Bertozzi. But in the Ecuador sample studied here, this can only explain a quarter of the 30% premium.

Monday, October 6, 2008

There are plenty of blogs trying to predict who is going to win the next Nobel Prize. Let's introduce some objectivity in this by using the RePEc rankings. Below, I look at various criteria and the three top papers or economists who have not yet won a prize.

Note that I have not used any criteria that puts more weight on recent citations, as I do not believe the prize committee thinks this way. There are a lot of macroeconomists above, probably a reflection of the fact that it is a wider field and thus people get more cited. But then, they should also get a proportional share of Nobel Prizes. Now, applying rigid rules is never a good way to perform forecasts, so let us through some subjectivity in there.

From the list above, Andrei Shleifer emerges as a favorite. His chances are, however, severely hampered by the Harvard-Russia scandal. That would leave Robert Barro, but I have a hard time imagining him getting the prize alone. With Thomas Sargent? The latter is one of those who have been extremely influential without being cited that much. In the same category are the often mentioned Eugene Fama and Kenneth French, who have the drawback of pioneering work in finance, and awarding the prize during the current financial crisis would reduce the credibility of the prize. This could also discount the chances of Lars Hansen, but his work on empirical asset pricing has had implication way beyond finance. Another personal favorite is Jean Tirole, who should have received it with Jean-Jacques Laffont before the latter died of cancer. Finally, let us not forget Paul Romer, who is fourth for several of the criteria above, including the very first one.

Thursday, October 2, 2008

We have just witnessed another example why the political process is broken in the United States. There is complete disregard of policy advice from people who understand the issues, staggering amounts of money is thrown at problems with policies that are ill-conceived from the start, are amended to make them worse, and then hastily packaged with other poor policies to "sweeten the deal".

In a nutshell, here is what is wrong: If the government buys the toxic assets, it will face a very serious adverse selection and buyer's remorse problem: it will only get the worst ones, and at a price well above the market. The idea to have a reverse auction on a good that is not homogeneous is also ludicrous. If the government can recoup 20 cents on the dollar for those toxic assets, it will be lucky. Remember that those assets will be pushed from people with little competence (banks) to incompetent ones (government).

There are other solutions. My favorite one is the Swedish one: have the government take equity positions, thus recapitalizing, force write-offs of bad assets, dilute shareholder value (shareholders are supposed to carry risk, remember), and then sell the stake once things are back to normal. This keeps incentives in the proper place, as banks continue to service the loans. The cost to tax payers was relatively minor when a similar situation happened in Sweden in 1992. Americans may not like this idea of partial nationalization, though. Alternatively, let those who are sitting on plenty of cash recapitalize, like in the Middle East or in Asia. UBS did this earlier in the year twice, as it was not expecting a bailout.

Another one is to get all problematic institutions through bankruptcy court. No tax payer money is involved (well, a little, to pay the courts) and it force the bad assets to be written off, and all can start afresh.

But stop scaremongering and claiming something needs to be done immediately and hastily. We have seen with the Iraq war and the Patriot Act how this can go wrong.

Wednesday, October 1, 2008

I have been trying on this blog to focus on other things than the current financial situation that everybody else is covering, but it is getting really difficult. The government is trying to find ways to get lending institutions to lend again, and guess what the FDIC is doing?

Preventing them from lending. That's right. The FDIC is going through the banks, looking at their balance sheets, readjusting the risk measures of the loans (I am fine with that), downgrading to junk anything that is related to real estate. That is problem number one: Not every real estate loan is poorly performing. In fact, most are still paying their mortgage every month, and will be until maturity. Forcing bank to basically write off every real estate loan is poor risk management. The consequence for most banks is that their rating with the FDIC is tanking, they must pay higher premiums to the FDIC and must recapitalize.

But it gets worse. The FDIC forces bank not to make loans, unless they are backed by cash. Banks are even asked to call back loans of well capitalized borrowers that were performing just fine. The FDIC is taking a wholesale approach killing all real estate loans, severing long-standing business relationships and basically negating all government efforts to get lending going again.

The FDIC has a mission, ensuring depositors can get to their money if needed. But it should not act in isolation of the other agencies, and it should not kill performing, sane business relationships. We definitely need to reduce the alphabet soup and merge the regulating agencies so that they can cooperate.